Oil Market Uncertainty Continues

As Reuters journalist Alex Lawler reminded us this week, “It used to be said of OPEC that it was like a teabag – it only worked in hot water.” If that’s the case, conditions on world oil markets require OPEC to step up to the plate, with crude oil trading at close-to-seven-year lows of $40 a barrel.

However, rather than closing ranks and forging some sort of consensus action, OPEC is finding that an intensifying battle for market share is driving it further apart – a situation made worse by deep regional differences between Saudi Arabia and Iran.

Whilst world leaders continued climate talks in Paris, OPEC representatives gathered in Vienna last Friday for a regular get-together. Little was expected in terms of any sort of agreement on output cuts, but what wasn’t expected was the level of acrimony amongst OPEC delegates.

According to sources, halfway through the six-hour meeting, an unexpected dispute erupted over the defining feature of the cartel. In a move most likely masterminded by Saudi Arabia, ministers agreed for the first time in decades to drop any reference to OPEC’s output ceiling.

The output ceiling was the mechanism that had defined OPEC since it was set up 55 years ago and provided its reason for existence. It allowed the organization to influence crude prices by adjusting supply to meet prevailing demand conditions. When prices were low it would reduce the amount of oil coming onto the market in order to support prices, whilst it would raise production during key boom demand periods in order to try and prevent price spikes – and avoid end-users turning towards alternatives.

OPEC has long had a desired price target of at least $80 per barrel (and preferably $100), which it feels necessary in order to provide financial incentives to maintain long-term security of supply – in other words, ensuring infrastructure is maintained and expanded to meet demand growth, whilst also ensuring exploration dollars are spent to ensure the oilfields of tomorrow are discovered.

As the graphic above clearly shows, between 2011 and 2014 OPEC enjoyed a strong oil price environment above $100 a barrel. This period however also coincided with the rise of shale oil production in the USA – a potential oil source known about for decades but never able to become a commercial reality due to technical challenges.

Shale’s rise was brought about by advances in reservoir and production technology, as well as the strong crude price – which made the burgeoning industry in the US a lucrative one. All of this shale production however changed the dynamics of the oil market and contributed to the price crash from $110 in late 2014 to $40 that we see now.

With oil prices plummeting, there has obviously been little incentive to spend money on finding new oilfields, whilst maintenance of essential infrastructure inevitably falls by the wayside as companies cut costs.

Returning to the OPEC meeting last Friday, the catalyst for the move to drop output quotas (which surprised both energy markets and many OPEC officials) appears related to tensions between Saudi Arabia and its arch-rival Iran - which has made clear it intends to make a rapid return to global oil markets next year when nuclear-related sanctions are lifted.

With Iran looking to pump as much as 1 million barrels per day (bpd) more crude (around 1% of world supply) into a market already saturated with excess supply, maintaining or legitimizing any pretence of OPEC limits was obviously not an option for Saudi Arabia.

The reality is that over the near-term, the outcome of Friday's meeting will probably result in little meaningful change to global oil markets. Since 2014 most OPEC members have been pumping oil madly in order to defend their market share from the new kid on the block - US shale oil production. Their objective has been to drive US shale out of business.

OPEC’s strategy has been based on the widely-acknowledged fact that US shale producers have a much higher operating cost base than most conventional oil producers – and therefore won’t be able to survive a prolonged period of price weakness due to evaporating operating margins.

The key component of OPEC’s strategy is sustained pressure, as whilst OPEC acknowledges that cutting its own production could generate a desired short-term positive price outcome (as it has in the past), it is sensible enough to know that any price gains could quickly unravel as US shale oil becomes profitable again – and comes back into the market in greater volumes. OPEC is not the market force that it once was, with non-OPEC production led by Russia and the US increasing annually.

Despite this market reality, many higher-cost OPEC members have been urging Saudi Arabia to restrict oil output in a vain bid to try and support prices. Many OPEC members are selling less oil at increasingly weaker market price levels, with no end in sight to the price capitulation. This in turn is putting economic pressure on the budgets of many oil producing nations, leading to potential political instability.

The reality is that OPEC’s nominal 30 million bpd output ceiling has for years largely been symbolic and in practical terms ignored. However the group’s abandonment of the pretence of production restraint could intensify the price wars between OPEC members - leaving them even less likely to agree on any market measures down the road.

The situation is intensified by the current Sunni-Shia conflicts that have seen Saudi Arabia and Iran coming to blows, particularly in Syria and Yemen. As Aberdeen Asset Management's investment strategist, Robert Minter, commented: "The fact that Iranian-backed Houthi militants are squaring off against Saudi-led troops in Yemen is not helpful, as increased Iranian oil revenues are likely to find their way to Iranian military interests in Yemen, Iraq and Syria."

So the outcome is that OPEC currently has no overall production targets for at least the next few months, but could come together again to agree new ones when Iran returns to the market in 2016. By that stage, OPEC members will be hoping for even more pain for US shale producers as a result of prolonged low prices, which would further damage shale output.

Conclusion

Whilst outsiders might view the image of OPEC in chaos as a positive, there are two points of concern. Firstly, prolonged periods of low prices have always typically resulted in subsequent sharp price spikes, as production infrastructure becomes degraded and investment in new discoveries ceases. Whether the cycle will play out again this time remains to be seen, as perhaps the advent of non-OPEC oil will cap any substantial price rise. This is the biggest question hanging over oil markets.

The second point of concern lies with expensive non-OPEC production. US shale interests might be rejoicing in OPEC’s current disarray, but there’s little reason for them to smile. US shale is set to be the biggest loser out of OPEC’s no-ceiling decision, as low-cost conventional producers like the Saudis and Iran can effectively churn out as much oil as they like – sending oil prices lower for longer as they further attack the already-questionable economics of many US shale producers.

Heavyweight OPEC producers have a far greater capacity to ride out the storm, especially as they have already endured a couple of years of pricing pain. Put simply, strong oil prices between 2011 and 2014 boosted the economics of shale energy and whilst shale can produce vast volumes of oil, it comes at a relatively high cost.

The once certainty is that there’s little prospect of oil price recovery anytime soon, certainly not within the next 12 months I would think, unless we see significant geopolitical risk factors come to the fore. Given the extraordinary political volatility in the Middle East at present, this cannot be ruled out.

After a decade as a broking resources analyst with Intersuisse, Gavin helped establish the Fat Prophets Mining Report during 2005, writing and producing the report until he established MineLife during late 2010. He writes about mining and energy companies via his MineLife reports.

Disclaimer: Gavin Wendt, who is a director of Mine Life Pty Ltd ACN 140 028 799, compiled this document. It does not constitute investment advice. In preparing this report, no account was taken of the investment objectives, financial situation and particular needs of any particular person. Before making an investment decision on the basis of this report, investors and prospective investors need to consider, with or without the assistance of a securities adviser, whether the information is appropriate in light of the particular investment needs, objectives and financial circumstances of the investor or the prospective investor. Although the information contained in this publication has been obtained from sources considered and believed to be both reliable and accurate, no responsibility is accepted for any opinion expressed or for any error or omission in that information.